Wednesday, February 20, 2013

Linn Energy's Queen Gertrude Moment

Linn Energy (Nasdaq:LINE) is the biggest oil-and-gas production Master Limited Partnership (MLP) in the US. The market cap is a little over $7 billion and there is a little over $7 billion in debt.

Like many MLPs it raises a lot of money and it pays big, fat and increasing dividends.

I have a number of listed companies including Linn Energy on "Ponzi watch" because they could potentially be Ponzis attracting capital with large and increasing dividends in an ultimately unsustainable spiral.

There are two things that make Linn Energy stand out. One is the voraciousness with which it raises money and the innovative ways it chooses to do so. In 2009 it raised $292 million. In 2010 it raised $844 million in equity and borrowed over $1.1 billion net. In 2011 it raised a further $679 million and borrowed another $1.2 billion. In 2012 until September it raised another $761 million and borrowed over $2.8 billion net. (Source cash flow statements from the last 10-K and 10-Q.) The company is the most innovative money-raiser in the MLP space having made a parallel structure (Linn Co - NASDAQ:LNCO) to appeal to institutional investors.

The second thing which makes Linn Energy stand out is their strange hedging policy. Linn Energy buys in-the-money puts. It also appears to have entered in-the-money-swaps on gas it intends to sell.

It sells the gas and collects money on its puts and its swaps. The proceeds when the puts and swaps are exercised is considered as distributable income. This is bizarre - so bizarre that I could scarcely believe it was real.

It was as if I owned a Microsoft Share with a market price of $28. And for $12.90 I purchased a $40 January 2014 put for it. [This contract is real - it can be purchased.].

Then come January I exercised the put, sold my Microsoft Share for $40 and declared a big capital gain. I told my clients all about the capital gain and told them they could spend it. I even gave it to them in distributions. And I told them to ignore the $12.90 I paid for the put which I had amortized away. After all the put premium disappears in depreciation and amortization - and amortization is a non-cash expenses.

If a mutual fund did this I would call it fraud. But just as the water goes down the bath hole differently in the Southern Hemisphere what is fraud in a mutual fund is acceptable in a very large MLP. Much to my disbelief Linn Energy seem to do precisely this.

-----------

Recently some anonymous short seller argued that Linn Energy's accounts were fake because they were doing precisely what I said they were doing above. Barrons recently made similar points.

Whatever - the short seller said (according to the MLP) that the MLP purchased "deep in the money" puts. This led to an amazing 8-K released by Linn Energy - an 8-K leaves me thinking of almost nothing except Queen Gertrude in Hamlet saying "methinks the lady doth protest too much".

This blog post repeats the whole press release with annotations. The original is in italics.

LINN’s Hedging Strategy and Response To Inaccurate Statements

Made By An Anonymous Short Seller

“Since our IPO, hedging our oil and natural gas production has always been an important strategy for the company and our investors. Our hedge strategy has served LINN and our investors well through a variety of commodity price cycles,” said Mark E. Ellis, Chairman, President and Chief Executive Officer. “Hedging will continue to be an integral part of LINN’s strategy.”

Below is an overview of the company’s hedging strategy and the company’s comments related to inaccurate statements made by an anonymous short seller.

Typically budget up to 10% of the cost of an acquisition for put expenditures

This last line is an admission that they buy puts and capitalize them. They also own gas swaps (ie forwards) which are a long way out of the money. Do they also budget cost for buying those? I would like to know.

Fact #1 – LINN is confident in the validity and accuracy of its audited financial statements.

Well they would say that wouldn't they? However there is no allegation I am aware of that the P&L or the balance sheet is incorrectly stated. The allegation is that EBITDA (which is not a GAAP concept) is overstated and they are paying unsustainable distributions.

Indeed the idea that they are paying unsustainable dividends is supported by their audited accounting statements. Linn Energy made an audited GAAP loss of $298 million during 2009. It paid $303 million in distributions. It made an audited GAAP loss of $114 million in 2010 and paid $366 million in distributions. In 2011 it made a (rare) profit of $438 million and paid $466 million in distributions. (Source: the last 10-K).

The last 10-Q reveals the situation has worsened: Linn Energy made a loss of 199 million in nine months - but it made 430 million loss in the last quarter. And it paid distributions of 426 million.

The pattern is increasing losses and increasing distributions - something that would be a standard feature in a Ponzi.

As a short seller I am relatively confident in the accuracy of Linn Energy's audited accounts. Far more confident than I am in their definition of distributable EBITDA.

Since the company’s IPO in 2006, LINN has paid its distribution for 27 straight quarters. These distributions were paid in CASH.

•

Amortization of puts is a non-cash expense and should not be deducted from EBITDA (hence the definition of EBITDA; earnings before interest, taxes, depreciation and AMORTIZATION).

•

LINN considers the cost of puts as a “capital” investment and views it as an additional cost of an acquisition (hence the target to spend up to 10% of the cost of an acquisition on puts). No one disputes that “depreciation” of oil and natural gas assets should be excluded from EBITDA or distributable cash flow because it is a “capital” expense, and the company views puts the same way.

•

When LINN purchases puts, the company pays 100% of the cost in upfront cash and capitalizes them as an asset on the balance sheet.

•

The cost of LINN’s puts is deducted from Net Income over time. Net Income is not a cash metric.

•

What does flow through to Distributable Cash Flow per Unit is the cost of debt and equity securities (interest and distributions) that were needed to purchase both the oil and natural gas assets and the puts. This is a CASH expense.

•

Anonymous short sellers are improperly mixing the definitions of cash flow and non-cash flow metrics (Net Income vs. Cash Flow).

This is a straight admission of the short-case against Linn Energy. Linn Energy buy puts. They pay money for these. They do not consider amortization of those puts an expense that should be deducted from their "distributable amount". They admit it should be deducted from the GAAP income.

This is an absolute analogue of me buying $40 puts on Microsoft and considering the gain when I deliver my Microsoft shares to be distributable. [Of course my GAAP accounts will tell the truth. Linn Energy's GAAP accounts also tell something approximating the truth. The truth is that Linn Energy is a loss making enterprise.]

Fact #3 – LINN does not always buy “in the money” puts.

•

Most of the company’s hedge positions consist of swaps (approximately 70%), which are entered into on “market” terms.

Now here is where the company completely loses me. All this legerdemain is alright because most of it is done through swaps on "market" terms. The give-away is that the word "market" is in inverted commas. You see this is a definition of "market" that I am not normally familiar with...

In particular the company swaps seem to be at the same price or higher than the company puts. And the puts are purchased "in the money". Moreover they invest money in their swaps so the swaps are purchased in the money.

You can see this in the last 10-K. In 2012 the price of their gas swaps is $5.85 (a fair way in the money). The price of their puts is $5.83. There is not much difference. There is not much difference in the out years except that for 2014 the price of their swaps is $5.69 and the price of their puts is only $5. In some years it seems the company "invests" just as much in their swaps as in their puts.

So they use swaps to fudge their distributable amount too.

•

The remaining balance of the hedge position consists of puts, the majority of which were purchased BELOW the market.

o

Out of 40+ hedging transactions over the last 10 years, only 7 were purchased “in the money.”

•

Some of the confusion arises due to the fact that certain investors do not know the difference between the prompt price (today’s price) and the 4, 5 or 6 year average market price.

o

For example, if the spot price for natural gas is $2.00 per Mcf but the 5 year average is $4.50 and LINN purchases a $5.00 put, that could hardly be considered “deeply in the money” when compared to the 5 year average market price.

o

When making decisions regarding spending money for puts, LINN focuses on achieving the best value for its money.

•

Additional confusion arises when some investors look at the price levels for the company’s hedge positions. This is largely due to the fact that most of LINN’s hedges were executed when prices were higher.

o

Obviously this is the reason the company hedged in the first place. LINN wanted to insulate the company from just such an event.

•

LINN has never and will never purchase deeply in the money puts to manipulate its cash flow stream.

I am just going to call BS on this. The company is claiming that it purchased substantial numbers of below market hedges. I want to point out the average price of gas sold after hedging in 2009, 2010 and 2011 was $8.57, $8,22 and $8.20 respectively. It is an awful long time since the natural gas prices - even forward natural gas prices - let alone say five year strip natural gas prices were that high. There is simply no way that these prices were obtained except by purchasing substantially in-the-money positions with large amounts of cash.

The last sentence - that LINN has never and will never purchase deeply in the money puts to manipulate its cash flow stream is a real Queen Gertrude moment as will be discussed below.

Fact #4 – LINN does not restructure its hedge book to manipulate earnings.

•

On rare occasions, LINN has restructured its hedge book.

o

One example was in 2008, when oil soared to $150 and LINN’s put strikes were approximately $70. At the time, that hardly felt like adequate protection. LINN paid a nominal sum to raise the strike prices for 2009 and 2010 to $120 and $110, respectively. First, both transactions were well BELOW the market, and second, oil later that year declined to a low of roughly $35.

•

Two other examples came in July 2009 and September 2011:

o

Both instances involved a precipitous decline in prices in the “long” part of LINN’s book (i.e. in years 4-6).

o

LINN realized gains of approximately $75 million by unwinding these positions. The company’s intent is always to leave the value in the hedge book instead of taking the cash. Therefore the company used the proceeds to raise hedge prices in near term years by a nominal amount.

o

Shortly thereafter, LINN rehedged the outer years again.

o

Bottom line is this is extremely rare and the magnitude of the trades is immaterial.

I agree LINN does not restructure its hedge book to manipulate earnings. The hedges are accounted for properly on a GAAP basis. What this does do is change its measure of EBITDA. In every instance they have reduced the price received in out years (reducing the EBITDA in out years) and increased the price received (and hence their measure of EBITDA) in the near-years. What they are doing is manipluating their dodgy definition of EBITDA and hence distributable cash flow.

They do this to continue to fake-up their distributable income and hence allow them to pretend to have a sustainable dividend.

They say the trades are immaterial - however the last 10-K contains this amazing section:

In September 2011, the Company canceled its oil and natural gas swaps for the year 2016 and used the realized gains of approximately $27 million to increase prices on its existing oil and natural gas swaps for the year 2012. In September 2011, the Company also paid premiums of approximately $33 million to increase prices on its existing oil puts for the years 2012 and 2013. In addition, during the fourth quarter of 2011, the Company paid premiums of approximately $52 million for put options and approximately $22 million to increase prices on its existing oil puts for 2012 and 2013.

Lets count that out. The company used 27 million of gains (taken out of 2016 hedges) just to increased their estimated distributable income in 2012. But that was not enough. So they paid $33 million to increase the price of their oil puts for 2012 and and 2013. They also paid 52 million for more put options and 22 million to increase prices on oil puts for 2012 and 2013. Funnily enough all this legerdermain is additional to the ones disclosed above in the press release.

This is beginning to look (a) material and (b) like a pattern.

The company says that it has never and will never purchase deeply in the money puts to manipulate its cash flow stream. That was the Queen Gertrude moment - after all they have a pattern of paying to make options and swaps more in the money to manipulate their cash flow stream.

Fact #5 – During 2012 LINN purchased $583 million of puts for the following reasons:

•

During 2012, LINN completed approximately $3 billion of acquisitions. Consistent with its hedging strategy to reduce commodity price volatility and lock in margins associated with the acquisitions, LINN purchased approximately $320 million of puts (again roughly 10%).

•

The remainder of the $583 million spent during 2012 was used to add puts for 2013 through 2017 for volumes that were not yet hedged.

•

As a reminder, this $583 million cost has a true finance cost (interest and distributions). The puts were purchased with cash. The potential benefit may not be realized for years to come. However, the cost is reflected now in LINN’s distributable cash flow per unit.

I have read this several times. All it means (I think) is that they paid out $583 million in cash which they will receive back when they sell gas and oil in the out years. That cash (which was borrowed as far as I can tell) will wind up being counted as distributable cash flow and be distributed. In a round about way then the company is borrowing to pay distributions.

Fact #6 – LINN’s publicly stated Adjusted EBITDA is the same that the company provides to its lenders.

Bluntly: Linn Energy uses the same misleading definition of EBITDA with the people it borrows from as it does with the unit holders. Does this make the lenders nervous? Should it make the lenders nervous?

Fact #7 – LINN’s taxable income is low relative to its cash flow.

•

The company’s taxable income due to non-cash deductions is relatively low compared to cash flow. So is every other oil and gas company.

•

LINN does not pay distributions with net income; the company pays them with cash flow and clearly has sufficient cash flow to do so.

I agree Linn's taxable income is very low relative to its cash flow. This company makes GAAP losses. It also - as far as I can tell makes tax losses - there is no taxable income.

Linn Energy however has raised its distributable cash flow with its strategy of buying in-the-money hedges. They just don't think that is faking EBITDA. I report: you decide.

Fact #8 – LINN only cancels out of the money hedge positions to comply with lender covenants.

•

On two occasions the company cancelled hedge positions, which happened to be out of the money at the time, to comply with its bank covenants when selling assets.

•

LINN also cancelled interest rate hedges when issuing long-term fixed rate bonds, again to comply with its covenants.

This is maybe the most extraordinary admission I have ever seen from a richly valued company. This company has has rejigged its hedging to comply with its covenants. Which covenants? Is it necessary to use this convoluted and unusual definition of EBITDA to comply with covenants? How do lenders feel about this? Do lenders even know they are being fed an unusual definition of EBITDA?

Fact #9 – LINN does not issue debt and equity securities to pay its distribution.

•

Since the company’s inception, LINN has issued approximately $12 billion of debt and equity securities:

~

$10 billion to finance acquisitions

~

$1 billion to finance puts (roughly 10% of the cost of the acquisitions)

~

$1 billion primarily to repay higher cost debt

•

Since its IPO, LINN has paid $2.4 billion in distributions. The only way that would be possible is by earning a sufficient amount of cash to pay the distribution, which LINN clearly did.

I agree the company does not raise money to pay distributions. Linn borrows money to buy things including put options and other derivatives. The money paid for these derivatives turns to cash as the company sells gas and oil at inflated prices. It is then distributed to unit holders.

Unit holders and debt holders would not countenance raising money to pay distributions. That is the essence of Ponzi.

So a really strange and opaque derivative maneuver gets inserted in the process. Then they sell equity and debt securities to buy derivatives that turn to cash. Then they distribute that cash. Whether interposing the strange derivative maneuver is sufficient to remove the whiff of Ponzi I cannot tell. I report: you decide.

As for the statement the only way that paying $2.4 billion in distributions would be possible if they earned the money - well I just present the GAAP accounts. All they have earned is losses. This company clearly has a different definition of "earnings".

Other Information:

•

In evaluating this issue, LINN has identified other publicly traded partnerships that purchase derivatives, and all of these companies account for derivatives the same way LINN does.

•

In fact, LINN has yet to identify any publicly traded partnerships that account for it differently.

•

LINN’s hedge policy strictly prohibits any speculative trading or manipulation in the hedge book. The company adheres strictly to this hedge policy.

The GAAP accounting is correct. I have said this above. What is unusual is the definition (non GAAP) of distributable amount. I have yet to see any other partnership that estimates its distributable amount in this way - but hey - there are always other things to short as well.

22 comments:

Anonymous
said...

You forgot to mention that LINE owns non-operated acreage in the North Dakota Bakken! The sure sign of a scam. They could even buy NOG at a 1-1 ratio and have it be accretive to distributable cash flow!

Once again a truly amazing analysis. I suspect that lots of E&P companies are playing games, they got away with murder in the mid 2000 when oil prices started rising (they were replacing light and sweet crude with heavy and sour crude), they made good because all ship are raised by the tide.

It remains that using these kinds of games has become rather common. In Canada, there is nothing wrong with raising cash to pay a dividend (look at Air Canada), several companies have done so (especially those wanting to reduce available cash for labour negotiations).

The details have always been in the notes, what is remarkable is that under GAAP rules they are more often then not unprofitable, while "everybody" seems to be mesmerized by the EBITDA figures... does not speak volume of our North American banks does it!

Here is one lie that you guys made that is easily refuted by just five minutes of actual research. I guess you forgot when nat gas prices were over $11 a few years ago.

"I am just going to call BS on this. The company is claiming that it purchased substantial numbers of below market hedges. I want to point out the average price of gas sold after hedging in 2009, 2010 and 2011 was $8.57, $8.22 and $8.20 respectively. It is an awful long time since the natural gas prices -- even forward natural gas prices -- let alone say five year strip natural gas prices were that high. There is simply no way that these prices were obtained except by purchasing substantially in-the-money positions with large amounts of cash."

Remember that Linn hedges 3-5 years out into the future. This is from a 2008 cc.

"Q): Hey guys, I actually have two questions for you. The first one is on the hedging, I think it’s great that you rolled up the hedges on the oil production. Just curious why you didn’t look to do anything in gas, with the big spike we had in gas recently as well?

"A) Michael Linn: Well, we looked at both of those, Dan, but quite frankly, gas had moved lower by the time we were executing these trades. So, if gas moves up again higher, I think we would look at that seriously because I think we picked some significant value. But with gas moving down towards the $9.00 range with our hedges at $8.50 there’s really not much to be gained there."

“I am just going to call BS on this,” Bronte’s John Hempton proclaimed. “The company is claiming that it purchased substantial numbers of below market hedges. I want to point out the average price of gas sold after hedging in 2009, 2010 and 2011 was $8.57, $8.22 and $8.20 respectively. It is an awful long time since the natural gas prices — even forward natural gas prices — let alone say five year strip natural gas prices were that high. There is simply no way that these prices were obtained except by purchasing substantially in-the-money positions with large amounts of cash.”

John,

You could buy 1 and 2 year forwards at these levels and above in 2008 (and no doubt 4 and year 5 forwards as well)

isn't this what they would have done?

not that this detracts from your central concern - which is asymetric accounting treatment plumping up apparent EBITDA.

here is a question though: Don't they have to write the cost of the put off once it is exercised ? so the unamortised put premium would be taken through P&L at the time the revenue is recorded on exercise of the put.

If that is the case, where is the harm?if that is not the case, where are the accountants ?!!

These arguments are going to fall on deaf ears for anyone who actually invests in the MLP space, because nearly all MLPs hedge to some degree and the closer you get to the E&P end of the spectrum, the more the companies hedge.

There's really no way to run an E&P business without substantial hedging. NG and Oil prices are simply too volatile. Buying puts and selling swaps (effectively equivalent to writing a call) are the two primary mechanisms by which these companies hedge.

This same issue came up during the crash in 2008/2009 as well, with many investors not familiar with the MLP space coming to believe that the E&P's were completely doomed due to not understanding their hedging or the multiple ways they had to raise cash. Combined with forced selling by hedge funds and margin calls, this caused prices to blow down to insanely low valuations. But it didn't last. Sanity returned to the markets and investors suddenly realized that the MLPs were not about to go bust, or anywhere near going bust.

So in many respects you guys are crying wolf after it's already been cried. It won't work the second time.

That said, anyone with experience in the MLP space, particularly the energy MLP space, knows what the risk is. The risk that prices might remain depressed far longer than the companies hedge books can handle and still make a profit. But this sort of outcome is not really a ponzi scheme... the companies will cut their distribution if/when the circumstances require (as they have in the past). It is this risk that investors must understand about the space.

Also, one final note: All energy MLPs raise cash through a combination of their revolver, capital raises, and debt. Not just LINE. All of them. And, generally speaking, it's pretty obvious when these companies get into trouble simply by looking at DCF coverage and debt payment schedules (as we've seen with CHK). LINE isn't anywhere near being in trouble, yet.

The do expense the cost of the put through gaap pl. first the capitalize the cost and then run through pl as unrealized losses in derivatives. Then to get to adj ebitda they add it back. Essentially making the put free from an ebitda perspective.

So they book the gain when there is one. And when they buy an in the money put they can 'manufacture ' a gain since th intrinsic value is treated as a gain. And then they say....the puts we buy have no cash cost...

It may not be fraud, but it is misleading and overstates the steady state distributable cash flow.

Keep in mind this is an E&P company with an MLP wrapper. They have to try to create the illusion of stable cash flows to keep the high multiple which makes the whole model work. Without a high multiple they can't buy more assets which is the only hope they have to grow distributions...

Lastly....don't think that the analysts will ask tough questions. The banks earn too many fees from the m&a, equity offerings and debt raises these guys do.

I am an accountant. As John says, the GAAP accounting is right, but Linn draws attention to a nonGAAP number in deciding dividends and asserting performance. This is somewhat similar to what companies in Aus did many years ago, when they focused on a number called 'Profit before Abormals'. Only issue was that there was no such concept under the then Australian accounting standards. A colleague of mine drew ASIC's attention to this, and the clamped down hard.

If you focus on nonGAAP, you get what you deserve. When we teach it, we refer to EBITDA as 'profit without the bad bits' :)

I agree that LINE doesn't have sufficient "earnings" or Net Income to have paid $2.4 Billion in distributions. However, it isn't as bad as the GAAP numbers, in my opinion.

GAAP hedge accounting requires unrealized gains/losses on derivatives to be included in Net Income when a company like LINE doesn't "designate" its hedges as a Fair Value hedge, Cash Flow hedge, or Net Investment hedge. So, if LINE suffers a loss in fair value on a hedge before it is settled, it mus be reported as a GAAP unrealized loss on the Income Statement and reduces GAAP Net Income or increases a GAAP Net Loss.

So, let's say the current market price of oil is $96/barrel, and you want to hedge this price for 3 years, so you go out and buy puts so you can sell the oil for at least $96/barrel three years from now. Now, let's say that in 6 months that the price of oil has climbed to $100/barrel. Your puts have lost fair value, even though they haven't been settled yet. That unrealized loss in fair value has to be reported on the Income statement. However, your oil reserves, the hedged item, have risen in fair value, from $96/barrel, to $100/barrel. But this increase in fair value is not reported on the Income Statement to offset the loss of fair value of the hedge. Your reserves remain on the books at historical cost.

So, only one side of the impact of rising oil prices is reflected in GAAP numbers. This, IMO, distorts the GAAP numbers and makes them worthless without adjusting for the unrealized losses/gains on the derivatives. You've got to take them out of the GAAP numbers to get valid and credible Net Income or Loss numbers.

Adjusting for them puts LINE in the black about every year. IT's still not enough to pay for all the distributions, but it's not as bad as the GAAP numbers portray it.

See the link below. Under "Hedge Accounting", it states: "The accounting for derivative instruments at fair value creates a common issue for organizations thathedge risks using such instruments. Specifically, such organizations may face an accounting mismatchbetween the derivative instrument which is measured at fair value, and the underlying exposure beinghedged, as typically underlying exposures are recognized assets or lia bilities that are accounted foron a cost or an amortized cost basis, or future transactions that have yet to be recognized. Thisaccounting mismatch results in volatility in the financial statements as there is no offset to the changein the fair value of the deriva tive instrument."

The "mismatch" this article speaks of is what I am talking about. A hedge, not declared a hedge for accounting purposes must be reported on the Income Statement at fair value, before settlement. But the hedged item remains at historical cost less depletion/depreciation/amortization. This creates a mismatch and makes the GAAP number distorted and does not reflect the economic reality.

I'm sure all of this gibber-jabber about how what derivatives should be added to what line in what statement are entertaining to a certain class of CFA level iii candidates, but shall we take a step back?

If CFO less CFI is less than dist cash, then you have a red flag. Of course this is common given the insatiable appetite for growing Gordon's model and easy money to fertilize the weeds, but right here you have a company or some odd partnership entity that needs the aid of trusty old CFF to plug the hole.

Fret not thyself from which line comes the plug. Follow ons, converts, triple revolvers with a twist, it is all the same. Borrow to pay the dividend. Ponzi. (As an aside, my personal favorite is the DRIP. Using the dividend to pay the dividend...now that's the ultimate...that takes a mgmt team with some style to pull that wool) Just be sure to put something about IRR in your press release and maybe some thing about these aren't the droids you're looking for. Everything's fine.

The question here, JH, is what reverses the flow of money? To short the MLP Yield Monkey Army, you need a view on more than sketchy accounting or self dealing. Uncle Cletus dont care until he thinks he might not get his next check.

In china ADRs (have we all given up on that trade?), it was fear or distrust or whatever you want to call it that spooked folks away at the slightest hint of accounting whose water might be...lets say murky. But most of those companies weren't sending a check every month or so to income starved Cletus, Luke, Bo, Jesse, or John p coltraine.

EBITDA is a modified cash basis form of accounting. It includes components of both cash basis accounting (not counting interest, taxes or depreciation/amortization, or one or more of these) and accrual accounting (counting receivables/payables).

Because it includes components of cash basis accounting, where it fails to include some actual accrued costs of a company, it is not reliable as a determinate of the actual earnings or Net Income/Loss of any business.

Accrual accounting, and GAAP, are the ONLY recognized and sanctioned forms of accounting for public companies under the jurisdiction of the SEC, for many reasons. The Financial Accounting Standards Board (FASB) creates GAAP and it is supported by the AICPA and the SEC. Cash basis or modified cash basis accounting is rejected by FASB, the AICPA, and the SEC for reporting and financial statement purposes due to their inherent weaknesses in fairly reflecting the financial position and operating results for any period of time. These weaknesses also apply to EBITDA. It is not sanctioned or recognized by FASB, the AICPA, or the SEC.

To the Hilt said: "The question here, JH, is what reverses the flow of money? To short the MLP Yield Monkey Army, you need a view on more than sketchy accounting or self dealing. Uncle Cletus dont care until he thinks he might not get his next check. "

True, Uncle Cletus don't care until he thinks he might not get his next check, cause Uncle Cletus don't understand where the cash is coming from and doesn't understand where the Earnings come from and what actually increases the company's Net Assets/Net Worth. Uncle Cletus just says, "Show Me the Money!!"

The reality is that LINE has to have sufficient earnings or profit to pay ALL Distributions, but it doesn't. Far from it.

The only thing that will increase LINE's Net Worth/Net Assets is "Earnings" or "Net Income". These two terms are one and the same. Paying distributions from borrowing increases liabilities and decreases the company's Net Worth or Equity. Paying distributions from the issuance of Equity is just an exchange of equity for equity, it doesn't profit you a cent.

Line has to keep acquiring, borrowing, issuing equity to maintain distributions and to increase distributions because Net Income each year is not sufficient to cover them.

AT some point, it's my guess that debt will become so massive that banks will stop lending. That's when the bubble will burst, IMO. Uncle Cletus ain't gonna be none too happy about that.

Hey John - Long time, no speak, hope you're well. Completely agree with the above and we've been tracking this for a while. It has long stricken me that this is the same scam we've seen 100x but w/ a new flavor - they are doing the classic CFFO to CFFI switch in reverse. The "hedges" are initiated with acquisitions, so they are really part of the purchase price. To then book GAINS on the settlement of these hedges is equivalent to reverse amortization of goodwill! It's bizarre. If you run the numbers on their deals including the hedge costs, they are barely earning their cost of capital, which makes sense given they are buying from knowledgeable sellers and have no real operating advantage. Any net proceeds from the "hedges" should be viewed much like prop trading gains were at GS by investors - don't count them when they win, holler when they lose. Anyhow, this one is getting fun.

The blog made sense, however the scheme should be relatively easy to uncover if one look at the data over multiple years, since GAAP is alleged to be accurate here. From 2008 to 2012 book value per share has increased somewhat. Cash distribution was over $2.5 per share per year. So somehow the earnings must have covered the dividends.

The reason that GAAP accounting tends to be not that useful for E&P is that it is backwards looking. So the above statement, even if true, won't tell me what the future looks like. That is why for E&P one needs to look at cash flow and reserve replacement. I guess this can get exploited by people who only look at the cash from operations (which is equally meaningless as earnings). And MLP investors who only look at dividends just beg to be scammed.

Oops. I forgot that they raised equity capital at above book value so that could keep the bv per share artificially high for a while. Re-doing the math from 2007/12 to 2011/12 equity up by 1.4B, dividends payout 1.4B, equity raise 1.8B so aggregate comprehensive income were about 1B (over 4 years), less than the dividends payout. Very questionable valuation at 2x book and leverage is high as well. Your short thesis could work out well. Are you hedging out your risk exposure to nat gas/oil price rocketing up? Granted their hedged production position is to your advantage but outer year reserves could get valued up if commodity price explodes.

You may be right, but I do not see why they cannot just continue this scheme into the indefinite future. As long as people are willing to lend them money and they are a genuine business this can go on for quite some time...

After reading Mr. Bary's response to Leon Cooperman's comments, it becomes clear to me that Mr. Bary doesn't understand the GAAP accounting at all. He believes that LINE has suffered Net Losses in 3 out of the last 4 years, 2012 being a loss of ($222 million) he believes.

I've explained in detail in a previous post that the unrealized losses on derivatives used as hedges, which reduce GAAP Net Income, are mostly bogus. IT seems no one understands nor comprehends why these losses are mostly bogus, and doesn't give a damn. That is unfortunate because any investment based on such faulty understanding will result in you getting your ass handed to ya. Mr. Bary will be exposed as being "incompetent" for not understanding it.

LINE doesn't have the earnings to pay for all its distributions, IMO, but they have a lot more than what Mr. Bary believes.

See link below. An initial reported ($800,000) loss on a hedge turns into a $1,800,000 gain once the hedge is settled. Bottom line, to the degree the hedge is effective, the unrealized losses will not be realized, they are largely bogus. This applies in the same manner to LINE's hedges. Disregard at your own risk and injury. I'd suggest you forward this to Mr. Bary. At present he is totally incompetent and out to lunch in regards to LINE. It did not suffer losses in 3 out of the last 4 years, far from it.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.